Amazon (NASDAQ:AMZN) has been working on hiring IT engineers who can get top security clearance from the U.S. government as it continues to bid against IBM (NYSE:IBM) for building out a private cloud for the CIA. The company is touting its early entry in the cloud computing market as a competitive advantage over IBM. But it is hard to believe that Amazon can do anything meaningfully different than IBM, which specializes in the IT business.
Whatever the case may be, there is little doubt that Amazon is getting quite aggressive in expanding its web services business to leverage the growing demand for cloud computing and support its razor thin margins. We believe that getting the CIA contract will boost Amazon’s credibility and pave the way for more such deals. Although the growth in public sector IT spending has been low in the past few years, it is likely to increase as the economy picks up.
Amazon has priced its contract at around $148 million, which is a substantial amount when seen in the context of its web services revenues.  About 15 such contracts will effectively double the segment’s sales. Although the company has primarily catered to the private sector so far, there is meaningful opportunity in the public sector as well. IBM and Cisco have been involved in building out IT and networking infrastructure for governments around the world. About 20% of Cisco’s overall revenues come from the public sector, and the company saw a growth of 5% in its U.S. public sector revenues in Q3 fiscal 2013. 
The global demand for web services is growing rapidly due to enterprises moving their IT infrastructure to cloud, rising Internet usage and growing e-commerce volumes. Federal and state governments are likely to adopt this shift, thereby opening growth opportunities for Amazon. Let’s take a quick look at why web services business is important for the company.
The Demand For Web Services Is Growing
Cloud computing, which is one of the main web services offered by Amazon, has seen rapid growth in the recent years. We expect this to continue as enterprises look to cut their IT infrastructure costs. Although the economy in the U.S. is improving, Europe is still facing economic headwinds, and GDP growth in some of the emerging markets such as India and Brazil has slowed dramatically. Many businesses can leverage Amazon’s cloud computing business to lower their IT costs in order to create more room for interest payments. Besides being cost efficient, cloud computing’s advantages include the availability of virtually infinite computation resources as well as scalability, faster deployment and implementation.
Research firm Global Industry Analytics Inc. estimates that the cloud computing market will reach $286 billion by 2018.  This plays right into Amazon’s hands. Due to its reliability, global reach and well recognized brand, the company can be at the forefront of this growth. Despite the growing competition from Google and Microsoft, Amazon’s solutions remain well ahead in terms of their support for all languages and the provision of unlimited capacity. If the company grabs even 10% of this market in the next 6-7 years, there can be 5-10% upside to our price estimate.
Web Services Business Has Higher Margins
In the first quarter of 2013, Amazon registered growth of 22% which was primarily driven by its services segment that saw its sales jump by 45%. The story continued in the second quarter, also as enterprises continued to flock to Amazon. Besides helping big businesses, the company’s cost efficient web services are useful for young startups that may have cash restrictions. The aggressive ongoing price war between Google, Microsoft and Amazon suggests that the company enjoys considerable margins on these services. We believe that the growing popularity of these services will mitigate the negative impact of the costs associated with fulfillment centers that Amazon is opening to speed up the delivery of physical goods to customers. As more online retailers spring up and traditional giants ramp up their online efforts, Amazon will have to make additional investments and may face risk of profit decline as its margins are already very low. Expanding web services can help mitigate this risk to a certain extent.
Our price estimate for Amazon stands at $280, implying a discount of 5% to the market.Notes:
- Amazon Web Services, IBM battle over high-profile CIA cloud contract, The Washington Post, Sept 1 2013 [↩]
- UPDATE 4-Cisco profit beats Street, shares rise on outlook, Reuters, May 15 2013 [↩]
- Growing Focus on Cost Mitigation Spurs Demand for Cloud Computing Services, According to New Report by Global Industry Analysts, Inc., PRWeb, Aug 19 2013 [↩]